5.6 Losses May Be Disallowed on Sales to Related Persons

A loss on a sale to certain related taxpayers may not be deductible, even though you make the sale at an arm’s-length price, the sale is involuntary (for example, a member of your family forecloses a mortgage on your property), or you sell through a public stock exchange and related persons buy the equivalent property; see Examples 1 and 2 in this section.

Related parties.

Losses are not allowed on sales between you and your brothers or sisters (whether by the whole or half blood), parents, grandparents, great-grandparents, children, grandchildren, or great-grandchildren. Furthermore, no loss may be claimed on a sale to your spouse; the tax-free exchange rules discussed in Chapter 6 apply (6.7).

A loss is disallowed where the sale is made to your sister-in-law, as nominee of your brother. This sale is deemed to be between you and your brother. But you may deduct the loss on sales to your spouse’s relative (for example, your brother-in-law or spouse’s step-parent) even if you and your spouse file a joint return.

The Tax Court has allowed a loss on a direct sale to a son-in-law. In a private ruling, the IRS allowed a loss on a sale of a business to a son-in-law where it was shown that his wife (the seller’s daughter) did not own an interest in the company. Losses have been disallowed upon withdrawal from a joint venture and from a partnership conducted by members of a family. Family members have argued that losses should be allowed where the sales were motivated by family hostility. The Tax Court ruled that family hostility may not be considered; losses between proscribed family members are disallowed in all cases.

Losses are barred on sales between an individual and a controlled partnership or controlled corporation (where that individual owns more than 50% in value of the outstanding stock or capital interests). In calculating the stock owned, not only must the stock held in your own name be taken into account, but also that owned by your family. You also add (1) the proportionate share of any stock held by a corporation, estate, trust, or partnership in which you have an interest as a shareholder, beneficiary, or partner; and (2) any other stock owned individually by your partner.

Losses may also be disallowed in sales between controlled companies, a trust and its creator, a trust and a beneficiary, a partnership and a corporation controlled by the same person (more than 50% ownership), or a tax-exempt organization and its founder. An estate and a beneficiary of that estate are also treated as related parties, except where a sale is in satisfaction of a pecuniary bequest. Check with your tax counselor whenever you plan to sell property at a loss to a buyer who may fit one of these descriptions.

Related buyer’s resale at profit.

Sometimes, the disallowed loss may be saved. When you sell to a related party who resells the property at a profit, he or she gets the benefit of your disallowed loss. Your purchaser’s gain up to the amount of your disallowed loss is not taxed; see Example 4 below.

EXAMPLES
1. You sell 100 shares of A Co. stock to your brother for $1,000. They cost you $5,000. You may not deduct your $4,000 loss.
2. The stock investments of a mother and son were managed by the same investment counselor. But neither the son nor mother had any right or control over the other’s securities. The counselor followed separate and independent policies for each. Without the son’s or his mother’s prior approval, the counselor carried out the following transactions: (1) on the same day, he sold at a loss the son’s stock in four companies and bought the same stock for the mother’s account; and (2) he sold at a loss the son’s stock in a copper company, and 28 days later bought the same stock for his mother. The losses of the first sale were disallowed, but not the losses of the copper stock sale because of the time break of 28 days. However, the court did not say how much of a minimum time break is needed to remove a sale-purchase transaction from the rule disallowing losses between related parties.
3. You own 30% of the stock of a company. A trust in which you have a one-half beneficial interest owns 30%. Your partner owns 10% of the stock of the same company. You are deemed the owner of 55% of the stock of that company (30%, plus one-half of 30%, plus 10%) and may not deduct a loss on the sale of property to that company since your deemed ownership exceeds 50%.
4. Smith bought securities in 2004 that cost $10,000. In 2007, he sold them to his sister for $8,000. The $2,000 loss was not deductible by Smith. His sister’s basis for the securities is $8,000. In 2012, she sells them for $9,000. The $1,000 gain is not taxed because it is washed out by part of the brother’s disallowed loss. If she sold the securities for $11,000, then only $1,000 of the $3,000 gain would be taxed.
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